Theuro&Greece Explained

n January 1, 1999, eleven European countries officially adopted the euro (symbolized by ), replacing their national currencies. At first, the euro applied only to electronic transactions, but on January 1, 2002, euro banknotes and coins replaced paper Deutschmarks, francs, and other European currencies. The introduction of the euro was seen as the biggest step in European integration so far, and as a sign that the European national economies were becoming more closely tied together. Just after the euro celebrated its tenth birthday, the euro was in serious trouble, as Greece received its first bailout in May 2010. The story of Greece is a good example of the benefits and costs of a common European currency. To explain Greeces rise and its downfall, it is helpful to compare Greece with the largest country that uses the euro, Germany. THE BEGINNING OF THE EURO The process for countries belonging to the European Union (EU) to replace their national currencies with the euro began in 1992 with the signing of the Treaty of Maastricht (named after a town in the Netherlands). On January 1, 1999, eleven EU Member States officially started using the euro. They had met the five necessary criteria, including the Stability and Growth Pact (Box 1). In 2001, Greece officially joined the Eurozone. Since then, Slovenia (2007), Cyprus (2008), Malta (2008), Slovakia (2009), and Estonia (2011) have all adopted the euro, bringing a total of 17 countries into the Eurozone. Denmark, Sweden, and the United Kingdom decided not to join the euro in
Box 1: The Stability and Growth Pact

Figure 1: The EU Member States

Eurozone countries Other EU members

1999, but every country that has joined the EU since 2004 has been required to eventually adopt the euro at its national currency. The argument for replacing a national currency with the euro is economic simplicity. When these countries used their own currencies, if a business or tourist wanted to buy something in another country, they would have to exchange their money for that of the other country. Since exchange rates change over time, this means that something could cost one price one day and a different price the next. It is also harder to know if you are getting a good deal if prices are in different currencies. Finally, when you exchange

In order to make the euro work with 17 different countries, all members had to meet the two requirements of the Stability and Growth Pact: 1. Government Deficit: No greater than 3% of GDP annually 2. National Debt: Less than 60% of GDP These requirements were designed to prevent a country from not being able to pay its government debt and to ensure that one governments actions did not harm the other Eurozone members by weakening the euro.

IndianaUniversityNovember2011

Theuro&GreeceExplained
money, you must pay a fee. It was hoped that having a single currency for most of the EU would encourage Europeans do business with companies across Europe and allow Europeans to travel easily to other EU countries. This occurred as planned, and the economies of EU member states grew during the first ten years of the euro. In 1999, Denmark, Sweden, and the United Kingdom decided not to adopt the euro. These three countries were already among the most economically advanced in the EU, and they were worried about no longer being able to control their currency. In the Eurozone, the European Central Bank (ECB) in Frankfurt, Germany, would control the monetary policy for all of the Eurozone. The ECB is similar to the US Federal Reserve System, and it controls the supply of money. The UK had the additional reason not to join because its currency, the Pound, was already globally used in trade and finance, which benefited the British economy. Greece became the 12th member of the Eurozone in 2001, and at the time this appeared to be a good decision. Much of the Greek economy is based on tourism, and the euro made it easier for tourists from Germany, France, and other European countries to visit Greece. Companies and banks also became more willing to invest in Greece, because it used the same currency as Germany and France. After all, Greece had to meet the same rules as France and Germany to join the EU in the first place (Box 1). The Greek economy did very well for most of the 2000s (Figure 2), in part due to having the euro has its currency. LOSING COMPETITIVENESS Although it was not obvious at the time, many sectors of the Greek economy did not benefit from the euro. It was now easier to move goods and money across the Eurozone, but the euro also magnified differences between economies. Many of the northern European countries that used the euro had higher rates of productivity than Greece. For example, the average German worker produced more of a type of good per hour than the average Greek

Box 2: Losing Competitiveness and Exchange Rates To help understand changes in 2000 2010 productivity, think about two workersone Greek German Greek German Table A Greek and one Germanwho both make cups. Imagine that in 2000 (before Greece cups/hour 5 5 10 20 joined the Eurozone), a German makes 5 cups an hour at 5/hour, while a Greek wages/hour 5.00 5.00 10.00 12.00 worker produces 5 cups and is paid 5 drachma/hour (we will use the symbol for cost to make 1 cup 1.00 1.00 1.00 0.60 drachma). If Greeces exchange rate with Germany was 1.00 equal 1.00, then the two workers makes the same amount of money. Assuming that all other things are equal, the costs of the Greek and German cups are thus the same. However, if the exchange rate is 2.00 = 1.00, than a Greek cup is produced at half the labor cost of a German cup, clearly an advantage for the Greek company. To see this mathematically: Cost in euros = cost in drachma x exchange rate 0.50 = 1 x 1/2 If the exchange rate was 1.00 = 2.00, then a Greek cup would cost twice as much as a German cup (2.00 = 1 x 2/1). By 2010, Greek wages have risen faster than productivity. The cost of a Greek cup is more than that of a German cup. If Greece still used the drachma instead of the euro, and the exchange rate of 1.67 = 1.00 then the two cups could cost the same (0.60 = 1 x 1/1.67). However, Greece can no longer influence its exchange rate. To have Greek cups costs the same as German cups, the Greek cup company now only has two options: it can increase the number of cups made each hour or else decrease wages in order to Greek cups. Both of these options are harder than simply changing the exchange rate. 2

Theuro&GreeceExplained
Figure 2: Change in Greek Economy (Percent of GDP) Figure 3: Interest Rate on Greek and German Government Bonds

worker in the same industry. In addition, during the 2000s, wages increased in Greece (and many other Eurozone members) faster than in Germany. Historically, this problem was less important because a country could devalue it currency. By reducing the value of its currency, a country like Greece could still sell its products more cheaply than its competitors even though the costs of producing the good was increasing (see Box 2). However, Greece could not use this strategy, as it no longer had any control over its new currencythe euro. Thus, while Germany, which accounts for 20 percent of the total Eurozones economy was becoming more productive, Greece was at a disadvantage, as its productivity was not increasing faster than Germanys. This loss in productivity meant that, over time, many Greek firms became less profitable and found it harder to compete with German and other companies. FISCAL BENEFITS FROM THE EURO Greek workers becoming less productive than other Eurozone countries is a problem in itself, Greece found itself facing another problem in 2010. Since Greece was now using the euro, many banks and other investors thought that the Greek economy was similar to the German economy. After all, Greece had to follow the same rules about the size of its government deficit and government debt as the other members of the Eurozone. In addition, when Greece signed the Treaty of Maastricht, it agreed to a
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no bailout clause. This meant that it would be Greeces problem if it could not pay its debts, as the other Member States were not responsible to give Greece money if it could not pay its bills and loans. Thus, everyone expected that Greece would follow the rules. Banks and other investors wanted to buy Greek government debt, since they thought that Greece had become a much safer place to invest than it had been before 2001. The interest rate that the Greek government had to pay in order to borrow money declined dramatically. For much of the 2000s, the interest rate that Greece paid was almost the same as what Germany had to pay (see Figure 3). This meant that investors thought that the chance of Greece not being able to pay for its debt and default was almost the same as Germany, even though the German economy was much stronger and its debt was smaller. Since Greece was able to borrow much more cheaply than before it adopted the euro, it was able to borrow a lot more money than previously. Much of this money was used to pay for improvements to Greeces infrastructure, such as building new bridges and roads. This would help the Greek economy for years to come as it was now faster to move goods and people across the country. Unfortunately, some of the money was spent less wisely. For instance, Athens hosted the Summer Olympics in 2004, and the Greek government spent billions of euros on the games. The Olympics did bring tourists and euros to Athens, and Athens built new subway system as part of hosting the Olympics. Not everything, however,

Theuro&GreeceExplained
helped the Greek economy in the long run. For example, the Olympic Stadium is now rarely used. The Greece government debt continued to grow and started to grow significantly faster than the economy after 2009 (see Figure 4). THE FINANCIAL MARKETS RESPOND When the global financial crisis began in 2008, the Greek economy began to shrink (see Figure 2) and enter a recession, like most economies in the world. The Greek government now had to spend more money, as it had to provide assistance to unemployed Greeks. At the same time, tax revenues decreased. Unemployed people pay less taxes since they are no longer working. Also, property such as houses and factories often become less valuable in a recession, meaning that the tax revenue on this property also decrease. As a result, the Greek Government needed to borrow even more money to pay its bills. Its budget deficit and hence its debt increased dramatically after 2008. In addition, banks and other investors were now weaker due to the poor state of the global economy. These investors now started to realize that the Greek economy was not the same as the German economy and that Greece was borrowing a lot of money for the size of its economy. For instance, in 2000, Greek government debt became larger than the Gross Domestic Product (GDP) of Greece, which means that its government debt was now more than the total annual output of the Greek economy. The Stability and Growth Pact was supposed to prevent a country from having such a high level of debt, but by 2005, the rules were no longer really enforced. France and Germany (the two largest members of the EU) had broken the rules in 2004,
Box 3: Interest Rates Imagine that the Greek government needs to borrow 1 billion (that is 1,000,000,000). In 2008, Greece could expect to pay an interest rate of about 4 percent for 10 years to borrow this money. Thus, Greece will actually pay a total of about 1,480,000,000. The math is below: Total amount = principle x (1 + interest rate) number of years 1.48 billion = 1 billion x (1+0.04)10 Next, imagine that Greece must borrow another 1 billion, but it is 2010 and the interest rate for a 10 year loan is now 7 percent. Greece would now have to pay a total of 1,970,000,000 or 480,000,000 more than the previous year. In fact, by 2011, Greeces debt was about 340 billion and investors were asking for Greece to pay more than an interest rate of more than 25 percent. Clearly, Greece could not borrow at this rate for very long. 4

Figure 4: Greeces debt (percentage of GDP)

and instead of being punished, they rewrote the rules. As a result, Greece no longer had to follow the Stability and Growth Pact for the next six years. International investors now demanded the Greek government pay a higher interest rate on the money it borrowed, because they were becoming less sure that Greece would be able to pay back all of its debt (Figure 4). The problem soon began to spiral out of control. It was now more expensive for Greece to borrow money, but it still needed to borrow money. Not only was the government spending more than it received in taxes, but Greece also had to pay for all of the money it borrowed before. Finally, since interest rates were increasing, it had to borrow more for the same amount of money (See box 3 for an example). TOUGH TIMES Since Greece was part of the euro, its options

Theuro&GreeceExplained
for solving these problems were much more limited than if it still used its old currency, the drachma. By belonging to the Eurozone, Greece no longer controlled its own monetary policy. For instance, Greece could not just print more money to pay for its debts, since it no longer controlled the printing presses. Nor could Greece just devalue its currency to make its debt cheaper for itself. Devaluing the currency would mean that it would take fewer euros to pay for its debt in dollars. Again, this power belongs to the European Central Bank, not Greece. Since Greece only accounts for two percent of the total Eurozone economy, in the beginning of the crisis the European Central Bank was more concerned with the large Eurozone economies such as Germany than the relatively small economy of a country like Greece. Thus, Greece really only had two options to solve its financial problems. The first was for the economy to grow. This would make the government debt smaller compared to the Greek economy. However, as previously explained, the Greek economy was becoming less productive compared to other Eurozone countries. The Greek economy would have to become more competitive compared to other EU members in order to spur growth. Not only would this require Greeks to make difficult changes, but Greek debt was growing at such a fast rate that it would be difficult for the Greek economy to grow faster than its government deficit. The second option was for the Greek government to introduce an austerity program. The Greek government would spend less money while increasing taxes. This would reduce the size of the government deficit, meaning the government would have to borrow less. Eventually this plan would allow Greece to pay for its debt. To decrease the size of the Greek government budget, the government was forced to make many unpopular decisions. For instance, the retirement age was increased, as many Greek workers could retire at 55. Government employees saw their paychecks cut. The government also stopped hiring new workers, and then started firing workers. While these were salaries that the government did not have to pay, it helped increase unemployment without producing economic growth. The Greek government increased taxes to help pay its debt, but this solution did not work well
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either. Tax collection is very low in Greece, so increasing taxes does not mean that people actually paid the new taxes. The result was that the governments income from taxes did not increase as much as hoped. In fact, the economy went into sharp decline producing even less revenue and higher costs. THE BAILOUTS Unfortunately, while these austerity measures caused hardships among the Greek people and caused them to protest in the streets, the program did not solve the Greek governments financial problems. The interest rate on Greek bonds continued to increase and Greece still needed to borrow more money, but Greece could no longer afford these loans. In May 2010, Greece was forced to accept a bailout worth 110 billion ($145 billion) from the EU, the European Central Bank, and the International Monetary Fund (IMF). This money would help Greece continue to pay its bills for three years. In return for the money, Greece was supposed to continue its austerity program, make its economy more competitive, and privatize many of the companies owned by the Greek government. Although this bailout bought Greece some time, the Greek economy did not recover. In fact, it remained in a recession and shrank in 2010 and 2011. Thus, its debt continued to increase until it was almost 160 percent of GDP, making it one of the highest ratios in the world. In July 2011, the EU and others agreed to give Greece another 109 billion (then $157 billion), but it soon became clear that even this extra money would not solve Greeces problems. Investors were now starting to worry about other countries in the Eurozone. Ireland and Portugal had already received bailouts of 85 billion ($117 billion) and 78 billion ($110 billion) in November 2010 and April 2011 respectively. At the same time, people were starting to worry about Italy and Spain. Italy has the third largest economy in the Eurozone and its economy is about 6.5 times the size of Greece. Italy also has the third largest government debt in the world, worth 1.9 trillion ($2.5 trillion) by 2011. Spains problems were different. Its debt was actually close to the 60 percent limit of the Stability

Theuro&GreeceExplained
and Growth Pact. Its economy was very weak, as unemployment rose above 20 percent in 2010 and its banks needed more money. Investors feared that the Spanish government would need to borrow more money to help its banks. People worried that if Greece were to default, Italy or Spain would be next. Investors would also take their money out of these countries or increase interest rates for their debt, since they also used the euro. Like Italy, Spain is much larger than Greece, and the collapse of Spain or Italy would be a disaster for the Eurozone and might even led to the breakup of the currency area. CONCLUSION The EU was never designed to manage a crisis like the one it is currently facing, as the EU budget is very smallit is capped at about 1.25 percent of the total GDP of the 27 member states. In 2011, the budget of the EU was only 142 billion (about $200 billion). The US Federal budget was $3.82 trillion (about 27 percent of the total US GDP). The Stability and Growth Pact (Box 1) and the no bailout clause were supposed to prevent something like the current crisis from happening, but these rules were broken years ago. As a result, countries like Greece found themselves in trouble when their economies were no longer growing, and the EU was not able to help them out. Thus, this crisis has continued for over a year and dragged additional countries onto the European Debt Crisis. GLOSSARY National debt: The total amount of money that the Austerity: The government policy of reducing national or Federal government owes (also know as spending, benefits, and/or public services, often to the same as sovereign debt). decrease a deficit. Privatization: When a government sells a business Bailout: Giving money (sometimes a loan) to a or asset it owns to private investors. company or government to prevent it from running Productivity: The efficiency of production, usually out of money. measured in amount of something produced divided by inputs such as labor or materials. Default: The failure to pay back a loan. Devalue: To reduce the value of a currency relative Recession: The general slowdown in economic activity. Recession often means that the economy is to other currencies. shrinking. European Central Bank: The central bank that is responsible for managing the euro currency.
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European Union: A group of European countries (currently 27) that have agreed to make common decisions and abide by common agreements in many areas. Eurozone: The group 17 EU Member States (currently 17) that use the euro as their official currency. Exchange rates: The rate at which one currency will be exchanged for another. Government deficit: The amount of money that a government spends in a year which exceeds its tax revenue. Gross Domestic Product (GDP): The value of all goods and services produced within a country in a year. Integration: In the European Union, integration is when Member States agree to give sovereignty and powers to the European Union as a whole. Interest rate: The rate that a borrower must pay to receive a loan, in addition to the principle. Monetary policy: The process a government (or in the Eurozone, the European Central Bank) uses to control the supply of money.